Pattern day trader

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Pattern day trader is a term defined by the U.S. Securities and Exchange Commission to describe a stock market trader who executes 4 (or more) day trades in 5 business days in a margin account, provided the number of day trades are more than six percent of the customer's total trading activity for that same five-day period. As the trader is exposed to the danger of day trading and intraday risks and potential rewards, it is subject to specific requirements and restrictions.

Basic Summary[edit]

A FINRA (NASD) rule that applies to any customer who buys and sells a particular security in the same trading day (day trades), and does this four or more times in any five consecutive business day period; the rule applies to margin, but not to cash accounts. A pattern day trader is subject to special rules. The main rule is that in order to engage in pattern day trading you must maintain an equity balance of at least $25,000 in a margin account. The required minimum equity must be in the account prior to any daytrading activities. Three months must pass without a day trade for a person so classified to lose the restrictions imposed on them. Pursuant to NYSE 432, brokerage firms must maintain a daily record of required margin.

Rule 2520, the minimum equity requirement rule was passed on February 27, 2001 by the Securities and Exchange Commission (SEC) approving amendments to National Association of Securities Dealers, Inc. (NASD).[1]

Definition[edit]

A pattern day trader is defined in Exchange Rule 431 (Margin Requirement) as any customer who executes 4 or more round-trip day trades within any 5 successive business days.[2] If, however, the number of day-trades is less than or equal to 6% of the total number of trades that trader has made for that five business day period, the trader will not be considered a pattern day trader and they will not be required to meet the criteria for a pattern day trader.[3]

A non-pattern day trader (i.e. someone with only occasional day trading), can become designated a pattern day trader anytime if they meet the above criteria.

If the brokerage firm knows, or reasonably believes a client who seeks to open or resume an account will engage in pattern day trading, then the customer may immediately be considered a pattern day trader without waiting 5 business days.[4]

Source: Information Memo of Amendments to Rule 431 ("Margin Requirements") Regarding "Day Trading"[5]

Round Trip[edit]

Definition: The successful purchase and subsequent sale of forementioned purchased (stocks).

Day trading refers to buying then selling or selling short then buying the same security on the same day.[6] Interpretation for more complex situations seems to be left up to the individual brokerage firm, for example if you buy the same stock in three trades on the same day, and sell them all in one trade, that can be considered 1 day trade[7] or 3 day trades.[8] If you buy in one trade and sell the position in 3 trades, that is considered 1 day trade. Three more day trades in the next 4 business days will freeze your account (you can only close existing positions) for 90 days, or until you get $25,000 cash into your account, whichever comes first. This also applies to options. Forced sales of securities- for instance through a margin call- still count towards the day trading limits.

Requirements and Restrictions[edit]

Under the rules of NYSE and Financial Industry Regulatory Authority, a trader who is deemed to be exhibiting a pattern of day trading will be subject to the "Pattern Day Trader" laws and restrictions, which is treated differently from a normal trader. In order to day trade:

  • Day trading minimum equity: the account must maintain at least US$25,000 worth of equity.
  • Margin call to meet minimum equity: A day trading minimum equity request is called when the pattern daytrader account falls below US$25,000. This minimum must be restored by means of cash deposit or other marginable equities.
    • Deadline to meet calls: Pattern day traders are allowed to deposit funds within 5 business days to meet the margin call
    • Non-withdrawal deposit requirement: This minimum equity or deposits of funds must remain in the account and cannot be withdrawn for at least 2 business days.
    • Cross guarantees are prohibited: Pattern day traders are prohibited from utilizing cross guarantees to meet day trading margin calls or to meet minimum equity requirements. Each day trading account is now required to meet all margin requirements independently, using only the funds available in the account.
  • Restrictions on accounts with unmet calls: if the call is not met, the account's day trading buying power will be frozen for 90 days or until day trading minimum equity margin call is met again.

Day Trading Buying Power[edit]

The rule increases day trading buying power to up to 4 times a pattern day trader's maintenance margin excess. For example, if a trader has $100,000 worth of equities, the leverage ratio is 4:1 meaning that it can buy securities of up to $400,000.

For day trading in equity securities, the day trading margin requirement shall be 25% of either:

  1. the cost of all day trades made during the day; or
  2. the highest open position during the day.

If a client's day trading margin requirement is to be calculated based on the latter method, the brokerage must maintain adequate time and tick records documenting the sequence in which each day trade is completed. Time and tick information provided by the customer is not acceptable.

Not Defined for Cash Accounts[edit]

The Pattern Day Trading rule regulates the use of margin and is defined only for margin accounts. Cash accounts can not use margin, so there is no way to further restrict their use of margin, so there is no rule to classify them as engaging in Pattern Day Trading. They may still engage in day trading, even at a frequency that would classify a margin account as engaging in Pattern Day Trading, as long as this does not result in free riding, the selling of securities bought with unsettled funds before the funds have settled. Any instance of free-riding will cause a cash or margin account to be restricted for 90 days from purchasing securities with unsettled funds.[9]

History[edit]

NASDAQ further restrict the entry by means of "pattern day trader" amendments. On February 27, 2001, the Securities and Exchange Commission (SEC) approved amendments to National Association of Securities Dealers, Inc. (NASD) Rule 2520 relating to margin requirements for day traders. The NASD amendments to Rule 2520 become effective on September 28, 2001, while the NYSE amendments to Rule 431, which are substantially similar, information memo from NYSE became effective August 27, 2001.

Rationale[edit]

While all investments have some inherent level of risk, day trading is considered by the SEC to have significantly high risk. The Securities and Exchange Commission (SEC) makes new amendments to address the intraday risks associated with day trading in customer accounts. The amendments require that equity and maintenance margin be deposited and maintained in customer accounts that engage in a pattern of day trading in amounts sufficient to support the risks associated with such trading activities.

In addition, the SEC believes that people whose account sizes are less than $25,000 may represent less sophisticated traders, who may be more prone to being misled by advisory brokers and/or tipping agencies. This is along a similar line of reasoning that hedge fund investors typically must have a net worth in excess of $1 million. In other words, the SEC uses the account size of the trader as a measure of the sophistication of the trader. This rule essentially works as a stop-loss on an unsophisticated traders account, disabling the traders ability to continue to engage in day trading activities.

One argument made by opponents of the rule is that the requirement is "governmental paternalism" and anti-competitive in a sense that it puts the government in the position of protecting investors/traders from themselves thus hindering the ideals of the free markets. Consequently, it is also seen to obstruct the efficiency of markets by unfairly forcing small retail investors to use Bulge bracket firms to invest/trade on their behalf thereby protecting the commissions Bulge bracket firms earn on their retail businesses.

Another argument made by opponents, is that the rule may, in some circumstances, increase a trader's risk. For example, a trader may use 3 day trades, and then enter a fourth position to hold overnight. If unexpected news causes the equity to rapidly decrease in price, the trader is presented with two choices. One choice would be to continue to hold the stock overnight, and risk a large loss of capital. The other choice would be to close the position, protecting his capital, and (perhaps inappropriately) fall under the rule, as this would now be a 4th day trade within the period. Of course, if the trader is aware of this well-known rule, he should not open the 4th position unless he or she intends to hold it overnight. However, even trades made within the three trade limit (the 4th being the one that would send the trader over the Pattern Day Trader threshold) are arguably going to involve higher risk, as the trader has an incentive to hold longer than he or she might if they were afforded the freedom to exit a position and reenter at a later time. In this sense, a strong argument can be made the rule (inadvertently) increases the trader's likelihood of incurring extra risk to make his trades "fit" within his or her allotted three-day trades per 5 days.

The rule may also adversely affect position traders by preventing them from setting stops on the first day they enter positions. For example, a position trader takes 4 different positions in 4 different stocks. To protect his capital, he sets stop losses on each position. There is then unexpected news that adversely affects the entire market, and all the stocks he has taken positions in rapidly decline in price, triggering the stop losses. The rule is now triggered, as 4 day trades have occurred. Therefore, the trader must choose between not diversifying and entering no more than 3 new positions on any given day (limiting their diversification, which inherently increases their risk of losses) or choose to pass on setting stops due to fear of the above scenario, a decision which also increases the risks to higher levels than it would be present if the four trade rule were not being imposed.

Notes and references[edit]

  1. ^ FINRA Notice: SEC Approves Proposed Rule Change Relating To Day-Trading Margin Requirements
  2. ^ This is just a simple definition. The rules relating to the handling of day trading accounts and margin requirements is complex, with different cases and exceptions.
  3. ^ http://www.nyse.com/pdfs/im01-9Microsoft%20Word%20-%20Document%20in%2001-9.pdf
  4. ^ "Margin Rules for Day Trading". 
  5. ^ Information Memo of Amendments to Rule 431 ("Margin Requirements") Regarding "Day Trading"
  6. ^ "Day Trading Margin Requirements: Know the Rules". 
  7. ^ "Counting Day Trades". Day Trading. 
  8. ^ "ETrade definition of pattern day trading". 
  9. ^ SEC Office of Investor Education and Advocacy, "Trading in Cash Accounts: Beware of the 90-Day Freeze under Regulation T"